Concern among market participants over the ongoing outbreak of the COVID-19 virus appears to have spread from simply a short-term reduction in demand for petroleum products within certain Chinese provinces to a broader, though still short-term, impact beyond hydrocarbon consumption. Accordingly, the initial equity market impact was largely concentrated among energy-related equities but has spread to broad markets globally.
We believe the fundamental backdrop for the energy sector and midstream equities is much less scary than the price collapse just experienced. From a macro perspective, early data from the oil markets indicate global demand contracted about 2 million barrels per day during February, or about 2%. Therefore, based on a gradual recovery in demand, early estimates are starting to migrate towards full-year global demand growth of approximately 500,000 barrels per day, down sharply from original (pre-virus) expectations, but growth nonetheless. And, importantly, the US remains poised to supply this growing demand and holds ample storage capacity which could see increased utilization in the near term. Obviously, energy infrastructure, or midstream, assets are also required to meet the logistical challenge of bringing these volumes to export locations, storing, and loading them on internationally bound vessels, and thus midstream throughput growth remains well-positioned.
Despite the equity market volatility, we believe the underlying midstream business remains robust. In fact, fourth quarter earnings season is nearing completion and results are beating expectations and growth is solid. Through the end of February, 53 sector participants have reported fourth quarter financial results with EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, coming in 1.1% higher than consensus estimates and 7.1% higher than the preceding quarter.1 Further, distribution coverage for midstream entities is approximately 1.5x, and we estimate the sector’s free cash flow (FCF) yield to grow from about 3% in 2019 to approximately 6% in 2020.2 With an increase in FCF yield, we estimate more companies may initiate equity repurchase programs, which could help provide equity price appreciation. As a prelude to repurchase programs, there has been a marked increase in insider buying as management teams likely recognize that valuations are attractive with price-to-discretionary cash flow (a midstream energy metric that is comparable to price-to-earnings ratio) now at 6.6x as compared with the five-year average of 11.1x and near financial crisis lows.3
In our opinion, in late 2019 energy and midstream equities succumbed to a painful combination of de-risking, tax-loss selling, and apathy for still out-of-favor subsectors, leaving midstream MLP valuations at historic lows. While a recovery began in December, it was derailed by the COVID-19 outbreak. We believe much of the pressure we are seeing today is general, panicked de-risking, likely exacerbated by certain holders that utilize leverage and would be forced to sell.
1 Source: Company reports and Invesco SteelPath estimates, as of 2/28/20
2 Source: Invesco SteelPath estimates and Wells Fargo Securities, as of 2/28/20
3 Source: Invesco SteelPath estimates and Wells Fargo Securities, as of 2/28/20
The opinions referenced above are those of the author as of March 3, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
Energy infrastructure MLPs are subject to a variety of industry specific risk factors that may adversely affect their business or operations, including those due to commodity production, volumes, commodity prices, weather conditions, terrorist attacks, etc. They are also subject to significant federal, state and local government regulation.